Friday, October 21, 2011

Today saw a rather depressing milestone: the dollar has hit a new all-time low against the yen. This chart helps explain why: the yen's long-term appreciation against the dollar has been largely driven by the fact that inflation in Japan has been much lower than U.S. inflation since the late 1970s.

According to Japan's Nationwide General Price Index, prices are on average at the same level today as they were in March 1993. Meanwhile, over that same period, the U.S. Consumer Price Index has risen by 58%. This alone would account for a 58% appreciation of the yen vis a vis the dollar since 1993, since that is what would be required to keep prices stable between both countries (if the yen/dollar exchange rate had not changed, U.S. prices would have risen 58% relative to Japanese prices). So its not surprising to find that the yen has risen about 50% against the dollar since then. The green line in the chart above shows how the value of the yen should have moved over time in order to keep price levels constant between the U.S. and Japan. It moves consistently higher because U.S. inflation has been consistently higher than Japanese inflation.

The fact that the current exchange rate is 76 yen/$, while my calculation of Purchasing Power Parity is 117 yen/$, is one way of estimating how strong the yen is. I figure it's about 50% "overvalued" relative to the dollar, which means that a U.S. tourist in Japan would find that, on average, things there cost about 50% more than they do in the U.S. This is also an indication of how little confidence the world has in the underlying fundamentals of the dollar relative to the yen.

The yen hasn't been rising because Japanese inflation is low, Japanese inflation is low (in part) because the yen has been rising.

The Nikkei has also steadily fallen for the past 20 years. This is the price they have paid for a rising currency. Like the US, the Japanese stock market is heavily weighted with multinationals who receive a large portion of their earnings from abroad. If the US dollar started rising like the yen has for the past 20 year, US equities would tumble.

In the early 2000's Goldman also told the SEC that raising the cap on investment bank leverage from 20:1 to 40:1 would be a good idea, which was, sadly, granted by the Bush administration. In retrospect, this was insane ... it only took Lehman going to 30:1 to self destruct. Of course, that one worked out OK for Goldman, but not so hot for the rest of us.

Speculating on currency-denominated valuations, including the dollar-denominated valuations, is fool's gold -- better to denominate your equities and skills valuations in terms of good hard gold -- when you adopt "gold-denominated" thinking, you tend to get a much different picture of value -- by the way, I am not arguing for buying gold, simply the adoption of gold-denominated thinking -- in terms of gold, the price of a barrel of oil has changed hardly at all since 1948...

Public library--the above is a chart from the World Bank. Japan is sinking, sinking, sinking. It is not a healthy economy, and low birth rates and monetary policy seem to signal permanent decline and deflation.

If this is what a "strong yen" brings, we should pray on bended knees that we never have a "strong dollar."

Advocates of a strong dollar need to explain what has happened in Japan, and why a strong yen is associated with such relentless decline.

"Caterpillar Inc jumped 5.6 percent to $92.30 and led the Dow higher after the world's largest heavy equipment maker reported a 44 percent jump in quarterly profit on record revenues.

"When a big-name company like this reports numbers like these, that will help turn around talk about another recession," said Andrew Bodner, president of Double Diamond Investment Group in Parsippany, New Jersey.